The Capital Asset Pricing Model The McGraw−Hill Companies, 2001           272 PART III Equilibrium in Capital Markets     beta of all assets must be 1. Hence betas greater than 1 are considered aggressive in that in- vestment in high-beta stocks entails above-average sensitivity to market swings. Betas be- low 1 can be described as defensive. A word of caution: We are all accustomed to hearing that well-managed firms will pro- vide high rates of return. We agree this is true if one measures the firms return on invest- ments in plant and equipment. The CAPM, however, predicts returns on investments in the securities of the firm. Let us say that everyone knows a firm is well run. Its stock price will therefore be bid up, and consequently returns to stockholders who buy at those high prices will not be ex- cessive. Security prices, in other words, already reflect public information about a firms prospects; therefore only the risk of the company (as measured by beta in the context of the CAPM) should affect expected returns. In a rational market investors receive high expected returns only if they are willing to bear risk.     CONCEPT C H E C K ☞ QUESTION 3 Suppose that the risk premium on the market portfolio is estimated at 8% with a standard devia- tion of 22%. What is the risk premium on a portfolio invested 25% in GM and 75% in Ford, if they have betas of 1.10 and 1.25, respectively?       The Security Market Line   We can view the expected return-beta relationship as a reward-risk equation. The beta of a security is the appropriate measure of its risk because beta is proportional to the risk that the security contributes to the optimal risky portfolio. Risk-averse investors measure the risk of the optimal risky portfolio by its variance. In this world we would expect the reward, or the risk premium on individual assets, to depend on the contribution of the individual asset to the risk of the portfolio. The beta of a stock measures the stocks contribution to the variance of the market portfolio. Hence we expect, for any asset or portfolio, the required risk premium to be a